Analysis of Operating Activities

1. Chapter F14 Analysis of Operating Activities Electronic Presentationby Douglas Cloud Pepperdine University

2. Objectives 1.Explain the relationship between product pricing and sales volume in creating revenues and profits. 2.Explain how operating strategy affects a company’s return on assets. 3. Define cost leadership and product differentiation and explain how companies use their strategies to create profits. Once you have completed this chapter, you should be able to: Continued

3. Objectives 4.Evaluate operating performance by using accrual and cash flow measures. 5. Examine the return on equity and explain how operating, investing, and financing activities are interconnected. 6. Describe the primary components of an accounting system and how they are useful for understanding business activities.

4. Objective 1 Explain the relationship between product pricing and sales volume in creating revenues and profits.

5. sales net income revenues Return on assets x = sales total assets revenues OR Return on assets net income = total assets Operating Decisions Net income = revenues – expenses

6. Summary of Expected Assets and Expected Operating Results for Mom’s Cookie Company Exhibit 1 (in thousands) Assets Initial Investment Operating Results Year 1 Year 2 Current assets $1,000 Sales revenues $3,000 $3,600 Plant assets 4,000 Cost of ingredients (800) (960) Total assets $5,000 Depreciation (300) (300) Wages and benefits (700) (700) Other operating exp. (1,000) (1,000) Operating income 200 640 Interest expense (20) (20) Pretax income 180 620 Income taxes (54) (186) Net income $ 126 $ 434

7. Objective 2 Explain how operating strategy affects a company’s return on assets.

8. Profit marginis a measure of a company’s ability to create profit from its sales. Developing an Operating Strategy Net income Sales revenue Profit margin=

9. Sales revenue Total assets Asset turnover= Asset turnoveris a measure of of a company’s ability to generate sales from its investment in assets. Developing an Operating Strategy

10. Developing an Operating Strategy Profit margin x Asset turnover Return on assets= Return on assetsis the profit margin multiplied by the asset turnover.

11. Developing an Operating Strategy If return on assets is low, a company must sell a lot of its products to earn a reasonable profit.

12. Net income Profit Margin = Sales revenue $126,000 $3,000,000 = 4.2% Expected Profit Margin for Mom’s Cookie Company Year 1

13. $434,000 $3,600,000 = 12.06% = Expected Profit Margin for Mom’s Cookie Company Net income Profit Margin = Sales revenue Year 2

14. Sales revenue Asset Turnover = Total assets $3,000,000 $5,000,000 = 0.60 = Expected Asset Turnover for Mom’s Cookie Company Year 1

15. Sales revenue Asset Turnover = Total assets $3,600,000 $5,000,000 = = 0.72 Expected Asset Turnover for Mom’s Cookie Company Year 2

16. Net income Return on assets = Total assets $126,000 $5,000,000 = = 2.52% Expected Return on Assets for Mom’s Cookie Company or 4.2% x 0.60 = 2.52% Year 1

17. Net income Return on assets = Total assets $434,000 $5,000,000 = = 8.68% Expected Return on Assets for Mom’s Cookie Company or 12.06% x 0.72 = 8.68% Year 2

18. Objective 3 Define cost leadership and product differentiation, and explain how companies use these strategies to create profits.

19. Profit Margin, Asset Turnover, and Return on Assets for Krispy Kreme and Starbucks Exhibit 4

20. Cost Leadership and Product Differentiation Strategies Companies that keep their prices low to generate high sales volume use a cost leadership strategy. High profit margin companies use a product differentiation strategy.

21. Cost Leadership and Product Differentiation Strategies They compete by offering products with special features or qualities that customers are willing to buy.

22. Cost Leadership and Product Differentiation Strategies Starbucks is closer to using product differentiation than is Krispy Kreme.

23. Cost Leadership and Product Differentiation as Alternative Operating Strategies Exhibit 5 Operating Strategy Profit Margin Asset Turnover Cost Leadership Low High Product Differentiation High Low

24. Cost Leadership and Product Differentiation Strategies Advertising often emphasizes low prices and convenient one-stop shopping. Cost leadership companies typically buy and sell in high volume.

25. Objective 4 Evaluate operating performance by using accrual and cash flow measures.

26. Comparing Accrual and Cash Flow Measures of Operating Performance If a company does not convert its profits into cash, the profits are a misleading performance indicator.

27. Comparing Accrual and Cash Flow Measures of Operating Performance The ratio of operating cash flow to total assets is useful for comparing the operating cash flows of different companies.

28. A Comparison of Operating Cash Flows for Krispy Kreme and Starbucks Exhibit 6

29. Further Evaluation of Operating Strategy Inventory turnover is the ratio of cost of good sold to inventory. It measures the success of a company in converting its investment in inventory into sales.

30. Selected Financial Statement Information and Ratios Exhibit 7

31. $150,414,000 $12,031,000 12.50 = Further Evaluation of Operating Strategy Cost of goods sold Inventories Inventory turnover = Krispy Kreme—2001

32. $1,175,787,000 $221,253,000 5.31 = Further Evaluation of Operating Strategy Cost of goods sold Inventories Inventory turnover = Starbucks—2001

33. Further Evaluation of Operating Strategy A ratio related to inventory turnover is day’s sales in inventory, the ratio of inventory to average daily cost of goods sold.

34. Selected Financial Statement Information and Ratios Exhibit 7

35. $12,031,000 $412,093 29.19 = Further Evaluation of Operating Strategy Day’s sales in inventory Inventory Cost of good sold ÷ 365 = Krispy Kreme—2001 $150,414,000÷ 365

36. $221,253,000 $3,221,334 68.68 = Further Evaluation of Operating Strategy Day’s sales in inventory Inventory Cost of good sold ÷ 365 = Starbucks—2001 $1,175,787,000÷ 365

37. Further Evaluation of Operating Strategy Accounts receivable turnover measures the success of a company’s ability to convert revenues into cash.

38. Selected Financial Statement Information and Ratios Exhibit 7

39. $300,715,000 $19,855,000 15.15 = Further Evaluation of Operating Strategy Accounts receivable turnover Sales revenue Accounts receivable = Krispy Kreme—2001

40. $2,648,980,000 $90,425,000 29.29 = Further Evaluation of Operating Strategy Accounts receivable turnover Sales revenue Accounts receivable = Starbucks—2001

41. Further Evaluation of Operating Strategy Gross profitmargin measures efficiency in the production or purchase of goods for sale.

42. Selected Financial Statement Information and Ratios Exhibit 7

43. $150,301,000 $300,715,000 50.0% = Further Evaluation of Operating Strategy Gross profit Sales revenue Gross profit margin = Krispy Kreme—2001

44. $1,473,193,000 $2,648,980,000 55.6% = Further Evaluation of Operating Strategy Gross profit Sales revenue Gross profit margin = Starbucks—2001

45. Further Evaluation of Operating Strategy Operating profitmargin is an indicator of a company’s efficiency in controlling operating costs other than product costs.

46. Selected Financial Statement Information and Ratios Exhibit 7

47. $23,507,000 $300,715,000 7.8% = Further Evaluation of Operating Strategy Operating profit margin Operating income Sales revenue = Krispy Kreme—2001

48. $281,094,000 $2,648,980,000 10.6% = Further Evaluation of Operating Strategy Operating profit margin Operating income Sales revenue = Starbucks—2001

49. Objective 5 Examine return on equity and explain how operating, investing, and financing activities are interconnected.

50. Profit Margin Asset Turnover Financial Leverage x x = Net income Equity Net income Sales Revenues Sales Revenues Total Assets Total Assets Equity = x x Linking Operating and Investing Activities with Financing Activities Return on Equity